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Merkel Greek Strategy May Backfire

Mention of possible euro exit exacerbates European debt crisis.

Germany and France’s drive to force Greece to honor its euro commitments risks backfiring on Chancellor Angela Merkel and President Nicolas Sarkozy.

A week after the currency’s guardians declared for the first time that it is possible for the 17-nation bloc to shrink, U.S. stocks tumbled on concern German politicians are already creating exit chutes for the weakest members.

The sell-off suggests Europe’s crisis is spiraling into a new stage as investors bet on which countries are most likely to quit the euro, starting with Greece. The risk is that this will make it harder for debt-laden countries to convince investors they can get their finances in order and for policy makers such as Merkel, Sarkozy and European Central Bank President Mario Draghi to bolster the euro’s defenses.

“This is a dangerous phase,” Neil MacKinnon, global macro strategist at VTB Capital in London and a former U.K. Treasury official, told Bloomberg Television’s “On the Move” with Francine Lacqua yesterday. “All of a sudden, we’re talking about the future of monetary union in its current format.”

U.S. stocks dropped late Nov. 9 as news broke that members of Merkel’s ruling Christian Democratic Union party plan to debate a motion next week, allowing countries to leave the euro region. The Standard & Poor’s 500 Index fell as much as 1 percent. In Europe, the Stoxx 600 Index has lost 2.6 percent in the past two sessions.

Stocks rose today as Europe took steps to address its woes with former central banker Lucas Papademos becoming Greece’s interim leader. Italy’s Senate votes today on debt-reduction measures, paving the way for a new government that may be led by former European Union Competition Commissioner Mario Monti.

Merkel and Sarkozy ignited speculation that the euro area could contract near midnight on Nov. 2 in Cannes, France, when they warned outgoing Greek Prime Minister George Papandreou that a planned referendum on his country’s latest bailout must serve as a ballot on whether Greece wants to stay in the euro.

“The referendum will revolve around nothing less than the question: does Greece want to stay in the euro, yes or no?” Merkel said with Sarkozy beside her.

While the ploy worked and Papandreou shelved the referendum, it undermined the message of the euro’s founding treaty that membership was “irrevocable” -- a line Sarkozy and Merkel had stuck to in the two years since the crisis broke out.

No Escape

Sarkozy and Merkel opened a “Pandora’s Box,” said Stephen King, chief economist at HSBC Holdings Plc in London, this week. He was referring to the Greek myth in which the first woman on earth disobeys orders of the gods by opening a jar and unleashing evil around the world, leaving only hope behind.

Countries unable to play by the euro’s rules may now have to leave the bloc, upending the assumption that “once in the euro a country could never escape,” King said in a note to clients. Now “what’s true of Greece may now also be true of Italy.”

Italian 10-year bond yields surged to a euro-era high of 7.46 percent Nov. 9 as investors questioned the ability of its lawmakers to restrain the euro-region’s second-largest debt load after Greece. While the yield slipped to 6.58 percent today, the crisis shows signs of spreading to France. Credit default swaps on the euro region’s second-largest economy rose eight basis points to a record 204 yesterday, CMA prices showed.

Some politicians are already working on a plan to push out errant members that can’t get their finances in order. Merkel’s Christian Democratic Union may adopt a motion at an annual party congress next week to allow euro members to exit the currency area, Norbert Barthle, the ranking CDU member on the German parliament’s budget committee, said.

The drive was dismissed by other members of Merkel’s party. Germany will resist any attempt to reduce the euro to its strongest members, the parliamentary finance spokesman for the CDU said yesterday. “Such a shrinking process would be deadly for Germany,” Michael Meister said in a telephone interview.

Any pan-European appetite for a re-drawing of the euro’s boundaries may be on show Dec. 9 when leaders hold another summit, this time to discuss deepening euro-area convergence, tightening fiscal discipline and strengthening economic ties.

“They might be talking about an exit clause for the euro area after Greece,” said Daniel Gros, director of the Centre for European Policy Studies in Brussels.

It wouldn’t be the first time the strategy of Merkel and Sarkozy has ended up hurting rather than calming markets. Thirteen months ago, they agreed at the French resort of Deauville that private investors must contribute to future European bailouts. The resulting bond-market selloff played a part in Ireland and Portugal subsequently requiring bailouts.

Any change in composition would validate the opinions of academics and investors including Harvard University’s Martin Feldstein and Mohamed El-Erian, chief executive officer of Pacific Investment Management Co.

Feldstein, who warned in a 1998 paper that monetary union would prove an “economic liability,” and El-Erian both say ensuring the euro’s existence may require a smaller, stronger bloc.

A report last month from the London-based Economist Intelligence Unit, titled “After Eurogeddon?,” said any fracturing would likely leave the euro in the hands of a strong northern core featuring Germany, Austria, Belgium, Finland, Luxembourg, the Netherlands, Slovakia, Slovenia and Estonia.

While France would suffer from a likely surge in the new euro, it would remain a member because its monetary union with Germany is fundamental to France’s political and economic interests, the report said. Greece would be first to leave followed eventually by Portugal, Ireland, Italy, Spain, Malta and Cyprus, it said.

“If they push out weaker countries and the euro stays, it would represent a smaller number of countries, so the currency should be stronger,” said Nicola Marinelli, who oversees $153 million at Glendevon King Asset Management in London. “But we don’t know the knock-on effects that could come from a country leaving so there would be a period of great uncertainty and weakness.”

Great Depression

European leaders will still do their utmost to keep the euro-zone in its current form, said Marc Chandler, chief currency strategist at Brown Brothers Harriman & Co. in London.

“Rather than break-up, the solution for Europe’s crisis will be more integration,” he said. “European officials, including Germany and France, in word and deed recognize the important of preserving the euro zone as currently constituted.”

A breakup could threaten a repeat of the Great Depression, HSBC’s King said in an analysis last month. For the exiting country, the banking system could face collapse, capital controls would be needed to stop citizens moving savings out of the country and companies would face default. On top of that, inflation would spiral, technical problems such as updating computer codes would be required and the accompanying departure from the European Union would leave it subject to trade tariffs, he said.

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